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Sterling, services and trade

Discussion about the effect of sterling’s depreciation on UK exports continues – but the focus of most analysis is still goods rather than services.

After reading this article published yesterday in the FT, I thought it was worth exploring in a bit more detail the oft-asked question of whether and to what extent sterling’s depreciation over the past year is likely to help exports—and particularly financial and related professional services exports. After all, as we have noted in our economic research, the financial and related professional services industry’s trade surplus is larger than the trade surpluses of all other net exporting industries combined. Could its positive contribution to the UK’s balance of payments position become even bigger?

At a very basic level, currency movements have two main direct effects: on inflation, and on trade. These are, of course, related, since the impact of currency appreciation/depreciation on inflation comes via the import channel. As far as trade is concerned, textbook economics stipulates that, all other things being equal, currency depreciation will boost export growth (as exports become relatively less expensive) and depress import growth (as imports become relatively more expensive, translating into higher inflation). This very simplified approach does not even begin to take into account factors like time lags, changing levels of demand in overseas markets, relative price movements, and so on.

The evidence on whether the economic reality in the UK has matched the theory is mixed. Since the EU Referendum last June, the pound has depreciated by 10.6% against the US dollar and 14.5% against the euro in nominal terms (the rates of depreciation over the last 12 months have been 0.7% and 6.5% respectively). Looking at the currency’s trade-weighted value, the Bank of England’s August Inflation Report, released yesterday, noted that the Exchange Rate Index (ERI) remains 15-20% below its 2015 peak.

As expected, inflation has risen significantly; annual consumer price inflation currently stands at 2.6%, up from 1.8% in January and a monthly average of 0.7% year on year in 2016.

On the trade side, however, export growth has thus far been negligible, and net trade continues to make a negative contribution to economic growth. Business surveys, however, indicate an expectation of more robust export growth in the months ahead:

But there are some important reasons that help explain why optimists may be disappointed. One is a fundamental change in the nature of global trade in recent decades; the increasing complexity and integration of global supply chains means that the effect of exchange-rate movements on import and export prices is more muted than it would have been in the past. This is not a UK-specific point; it is true more generally, in almost all countries. A UK-specific point is the idea that at least some of the benefits of sterling depreciation may have been accruing to companies in the form of higher profits; firms appear to have been keeping foreign-currency prices unchanged rather than reducing them in search of higher export volumes and/or larger market shares. As the Bank of England noted, “[Bank] Agents’ profit margin company visit scores…have generally been above normal for export-focused companies since late 2016, while those for domestic-focused companies have been below normal.”[1]

And what of financial and related professional services? Unlike (some) goods, services—and especially high-value services such as financial and related professional services—are not particularly price-sensitive. Demand for services provided by a UK bank in an overseas market via a branch or subsidiary, or by an accounting or consulting firm to an overseas client (to give just two examples), tends to be driven more by non-price factors like quality (since such services are generally highly differentiated rather than commoditised), or patterns of trade in non-financial and related professional services. (For emerging markets, import demand for UK-based financial and related professional services is more complex and encompasses a host of other factors, some of which are explored in this report from our Independent Economists Group. So although the UK’s trade balance may yet improve in the months ahead, a sterling-induced surge in financial and related professional services exports is unlikely to be on the cards.